Wasted Time

So you can get on with your search, baby
And I can get on with mine
And maybe someday we will find
That it wasn’t really wasted time

Those are the closing lines of one of the most beautiful songs the Eagles have ever produced, written by the duo of Don Henley and the late Glenn Frey.  The song was on their epic 1976 album Hotel California.  In late September last year, my wife and I flew to Las Vegas for a few days to see the band at the MGM Grand Arena, where they played the entire Hotel California album for the first time ever, along with many of their other hits.  With Wasted Time, partway through the song, the band unveiled a curtain so the crowd could see the nearly 40-member orchestra that was accompanying them on the piece.  It was absolutely beautiful.  

What does Wasted Time have to do with the financial markets?  I’m glad you asked.  Last week, a client had innocently asked “So, when do you think we’ll get back to where we were in February, before COVID came along?”  The right answer is, I have no idea, but it did get me thinking, and then I remembered a study Ned Davis had done on this subject, and that made me think of Wasted Time, and presto, I’ve got something new to write about.  Read on.

Wasted Time.  Not Necessarily.

I could be wrong on this, but in examining the lyrics to the song, it appears to be about a past relationship that fizzled, that it’s time to move on, but with the realization that the time spent in the relationship actually had some redeeming value.  In other words, it really wasn’t Wasted Time.  In essence, our client was asking, when stock prices decline, how long does it take to recover?  Several years ago, Ned Davis Research (www.ndr.com) produced the chart below, which shows the Dow Jones Industrial Average back to 1901.  The largest decline in history is very visible on the left side of the chart, when stocks fell over -80% during the 1929-32 time period.  This chart does not reflect dividends, but on a price-only basis, the Dow did not recover these losses until the mid-1950s.  

This is a pretty extreme example.  Since 1950, there have been 11 instances prior to February of this year when the S&P 500/Dow Industrials dropped from a previous all-time high.  In 7 of those 11 drops, it took only one year for the S&P 500 to recover all of its losses.  In the analysis that NDR did, they found that in the past, the stock market has spent about 41% of the time recovering from a loss, another 34% falling, and just over 25% of the time making new wealth.  Said another way, stocks historically have been making new all-time highs about once every four days.

Unfortunately, there’s no way to know what lies ahead.  After the 1973 peak in stocks, it took nearly 6 years to recover.  The 2000 peak took 8 years to gain back, while the 2007 top took another 6 years.  At present, it has been a little over 4 months since the S&P 500 peaked in February.  There was a -34% decline, followed by a 44% rally, but no new high (though I should note the NDX 100 is the only index which has made a new high).  The common theme, though, is that after each decline, stocks eventually recovered to new highs.  And therein lies the psychology, and one’s time horizon.  Everyone can be a bit different in that regard.  There is one sure thing, though, regarding the math, and it’s not symmetrical.  The more you lose, the more you have to gain back to recover.  A 50% loss means one has to gain 100% to get back to even.  

Investing, like any worthwhile endeavor, is not just about the end game, but the journey.  And often, that journey is two steps forward, and one step back (and sometimes, more than one step).  Looking at it through that lens, I’d say it’s definitely not Wasted Time.

A Dollar Sure Doesn’t Go A Long Way

I purchased my first home in 1987 in Placentia, CA for $167,000 and took out a mortgage with a 9.25% interest rate on a 30-year fixed loan.  Last week, one of our clients closed escrow on a refinance we recommended and the interest rate was 2.875%, saving them thousands of dollars per year in payments.  Before we all go celebrating on how great it is to get such a low rate, let’s remember there is another side to the coin, and it affects everyone with savings, not just someone who happens to own a home (side note—about 40% of all homeowners have no mortgage).

The other side of that coin is that we are now dealing with the lowest interest rates in history.  Money market rates at brokerage firms have declined to effectively zero in just two months.  For diversified portfolios with a bond component, the math is making it more difficult to achieve even reasonable levels of income without taking on more and more risk.  Look at the table below, which shows the path of the yield on the 10-year Treasury Note, back to 1968.

Some context is important.  This is depicting the yield on the safest of bonds, U.S. Treasury paper, where one really doesn’t need to worry about default risk.  Which means, if one wants/needs to earn 3% on the fixed income side of the portfolio, you have to venture into corporate credit, with varying degrees of risk.  For instance, you could go out 8 years with the Invesco 2028 Bulletshare (BSCS), and garner a yield of at least 2.50%, with a portfolio of bonds that is 61% rated A or better.  That’s considered an investment grade bond fund.  Or, you can venture into high yield bonds (junk), where yields are in the 5-6% range, depending on the fund.  The yield on junk is not a given.  There’s a reason the average high yield bond fund declined by about -20% from mid-February to March 23.  Credit risk.  But, you see my point.  You’re going to have to take on credit risk in order to get more return from the bond side of a portfolio.  There aren’t many people I know who can live on 0.67% annually, even if they had $5 million or $10 million.  

Effectively, the Federal Reserve Board is forcing investors to take more risk, and this may be one of the consequences of their actions.  

IRA Required Minimums Rolled Back

Earlier this year, as a result of the COVID-19 virus, the IRS suspended for the year 2020 the normal requirement for IRA account owners to take minimum payouts from their retirement accounts.  By then, though, a number of people had already taken their distributions for this year.  Normally, you can’t take money out of an IRA and roll it back in after 60 days.  But, the IRS changed course, and have now issued an updated ruling that permits anyone who has already taken their RMD for 2020 to put it back into the account, as long as the roll-back occurs by August 31.  I honestly don’t think the tax savings are going to be a big deal for clients (you’re going to have to pay the tax next year), but if for some reason you do want to undo what’s already been done, just let us know and we’ll collaborate on getting it put back.

Price Discovery With Corporate Bond ETFs

If investors didn’t know this already, they discovered it the hard way in the month of March, that bond ETFs are not the same as bond funds.  Bond funds are mutual funds, priced once per day, using a closing price, no matter whether one placed their buy or sell order at 9 am or at 12 pm that trading day, as long as it was entered and accepted before the 1 pm (Pacific time) closing of the financial markets.  ETFs, though, trade throughout the day, like stocks, and provide intra-day liquidity that funds do not.  Sometimes, though, that liquidity comes with a price.

In March, as stock and bond prices were plummeting, two of the largest bond ETFs in the industry, BlackRock’s iShares USD Investment Grade Corporate Bond ETF and the Vanguard Total Bond ETF, traded at their biggest discounts ever to their net asset value, over 5-6%.  This was a reflection of mass psychology, which was deeply pessimistic, as sellers wanted out so bad, they were willing to sell a fund that was worth $1 for only 94-95 cents.  Under stress, bond ETFs of all kinds effectively became closed-end funds, which trade at premiums and discounts all the time.  

In contrast, bond mutual funds are priced every day at net asset value and don’t suffer these issues.  In general, we absolutely prefer bond funds over bond ETFs, especially in the active space of high yield corporate funds, but we wouldn’t eliminate ETFs from consideration.  We actually own the Vanguard Total Bond Fund (BND) in TABR’s Passive Index Account, rather than the mutual fund version (VBMFX).  Why?  The former has an expense ratio of 0.035%, which is much lower than the fund at 0.15%.  Plus, at Fidelity, it costs $22 to buy or sell the fund, while the ETF can be traded for no commission, since the large firms like Schwab, Fidelity, TD Ameritrade and others eliminated commissions on equity trades last fall.  The main thing to be aware of is—if you are going to buy or sell during times of market stress, make sure you are not selling at a substantial discount, or buying at a substantial premium.  Unlike closed-end funds, premiums and discounts will typically disappear once conditions calm down.

Wasted Time—Reprise

With June 30 just a few days ago marking the first six months of 2020, I thought it might be appropriate to take a step back and see how the stock market has been doing since September 20, 2018, which is when the S&P 500 had made an all-time high at that time (prior to the one subsequently made in February 2020).  We are now over 21 months past that peak, and the table below there’s no uniform answer to the question of “how’s the stock market been doing in that time?”  It’s dependent on what you own.  Other than large cap growth, everything is negative and recovering from a loss.

All data above is using dividend-adjusted price (meaning dividends are included, as they should be).

The Current Market Environment And Portfolio Allocations

In the last month, stocks in general have been going sideways, as shown on the chart below of the S&P 500, courtesy of www.stockcharts.com.  There was a huge, one-day plunge on June 11 of nearly -6%, but not much follow through.  

There is very key support for the index in the 2960-3000 range, just below its 200-day moving average, and substantial resistance around the 3200 level.  A close either above or below these levels, which lasts for more than a couple of days, is likely to foretell the direction of the next significant move in the overall market.  The NDX is the only major index to make a new high.  Can it drag the rest of the market with it?  Anything is possible, but it’s also plausible the rest of the market will eventually drag the NDX down.  

Perhaps there is a clue in the recent behavior of high yield bond funds, which display a high correlation to stocks.  On June 16, the Fed unexpectedly announced they were going to be buying more individual corporate bonds.  It sparked a big rally that day in both stocks and bonds, with high yield bond funds gaining over 1% on the day.  Since then, the EFA, S&P 500 and NDX 100 have traded higher (but not mid caps and small caps), while high yield bonds peaked that day, and are about 1% lower on average.  This is a negative divergence.  High yield bond prices often lead the stock market, so this relationship bears watching in the coming weeks.

At present, TABR’s allocations are neutral.  Three of our five stock market risk models are negative.  While maintaining a 15% floor at all times, our tactical equity allocations are at 50%.  After some extensive research, we’ve recently reduced the number of stock market risk models we are using from 7 to 5, and are currently evaluating a 6th one to see whether or not it is good enough to add value over time.  In bonds, our high yield bond risk model turned negative on June 15, after a BUY signal on May 26.  Since February 28, our model for this area of the bond market has generated five signals in five months.  That’s unprecedented, and hopefully not an indication that this will become the norm going forward.  

Does Value Matter Anymore?

That is the question being tossed around on Wall Street, with considerable debate.  There’s one group who feels that historical models are broken, and are finding ways to be comfortable with high valuations.  There’s another group who is mostly opposite that thinking.

Below is a chart from Ned Davis Research that depicts the Price/Operating Earnings Ratio of the S&P 500 back to 1926.  

You can see that the 50-year average PE has been 16.05, but in the last 25 years, it has risen to 19.58.  This is no doubt due to lower interest rates and lower inflation.  But the current reading of 25.5 is nearly 25% above the 25-year average, and would require a decline in the index of nearly -30% just to get back to “overvalued.”  In this low growth and low yield environment, that requires a leap of faith that multiples will continue to expand in order to generate historically normal returns.  

We think that is a low probability event.  Please know we are not subjectively at 50% invested.  If our models all turn bullish, our equity allocations will go up to 100% until that changes.  The stock market may be telling us that all will be fine several months from now.  Or, it could be completely misleading.  I’m inclined to agree, though, with some recent thoughts of Howard Marks, the co-founder of Oaktree Capital Group in Los Angeles, CA, and one of the more thoughtful, and successful investors in the industry.  “The greatest bargains that we get are when we buy things that nobody else will buy at a time when there’s no money around,” Marks recently said in an interview with the Wall Street Journal.  “That’s not a very good description of today.”

In other words, this time ISN’T different.

Material Of A Less Serious Nature

Two men, sentenced to die in the electric chair on the same day, were led down to the room in which they would meet their maker.  The priest had given them last rites, the warden had given the formal speech, and a final prayer had been said among the participants.

The warden, turning to the first man, solemnly asked, “Son, do you have a last request?”  The man replied, “Yes sir, I do.  I love dance music.  Could you please play the Macarena for me one last time?”  “Certainly,” replied the warden.

He turned to the other man and asked, “Well, what about you?  What is your final request?”  “Please,” said the condemned man, “kill me first.”

There’s certainly nothing normal about this Fourth of July.  Maybe hot dogs and peanuts, but no baseball.  At least not until July 23, but who knows.  Please stay safe and healthy, and follow one of the many great thoughts of the late Martin Luther King, Jr., who once said, “Life’s most persistent and urgent question is, ‘What are you doing for others?”  Today, how about Wear A Mask?

Sincerely,

Bob Kargenian, CMT
President

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